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Saturday, September 25, 2010

Financial Metrics - Ratio Analysis Considerations

Ratios are important profit tools in financial analysis that help business implement plans to improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. While ratios report on past performance, they can be predictive too, and provide lead indications of potential problem areas.

Ratio analysis is primarily used to compare a company's financial figures over a period of time which is also called trend analysis. Through trend analysis, you can identify trends and adjust your business strategy accordingly. You can also see how ratios stack up against other businesses in the industry - benchmark.
There are several considerations you must be aware of when comparing ratios from one financial period to another or when comparing the financial ratios of two or more companies.

Comparative analysis of a company's financial statements over a certain perio d of time, make an appropriate allowance for any changes in accounting policies that occurred in that period.

Comparing you business with others in the industry, allow for any material differences in accounting policies between your company and the industry norms.

Comparing ratios from various fiscal periods or companies, inquire about the types of accounting policies used. Different accounting methods can result in a wide variety of reported figures.

Determine whether ratios were calculated before or after adjustments were made to the balance sheet or income statement, such as non-recurring items and inventory or pro forma adjustments.

Carefully examine any departure from industry norms.

The following are the types of ratios:

Income

Profitability

Liquidity

Working Capital

Bankruptcy

Long-Term Analysis

Coverage

Leverage

Additionally, when performing ratio analysis of financial statements, it is helpful to adjust the figures to common-size numbers. To do this, change each line item on a statement to a percentage of the total. For example, on a balance sheet, each figure is shown as a percentage of total assets, and on an income statement, each item is expressed as a percentage of sales.

This technique is quite useful when you are comparing your business to other businesses or to averages from an entire industry, because differences in size are neutralized by reducing all figures to common-size ratios. Industry statistics are frequently published in common size form.

The key then is to effectively communicate the trends to all levels of the organization. As Albert Einstein stated, “If you can't explain it simply, you don't understand it well enough.”